Bailout and Equity

The august investment firm of Lehman Brothers, founded in 1850, weathered the American Civil War, two World Wars and the Great Depression. Yet over a few days in September, the firm collapsed in the wake of the credit crisis that has roiled financial markets around the world. It was one of several stunning developments that included the sale of the venerable Merrill Lynch and the transformation of Morgan Stanley and Goldman Sachs into bank holding companies, as well as the government’s near-takeover of the mortgage behemoths Fannie Mae and Freddie Mac and the insurance giant American International Group. On Sept. 19 Treasury Secretary Henry Paulson Jr. asked Congress to allow the government to purchase $700 billion worth of problem mortgages to put an end to the crisis. Overall, the government bailouts could deliver a bill of $1 trillion.

Certainly there is enough blame to go around. Exper-ienced C.E.O.’s of giant financial institutions should have known better than to risk investors’ assets in complex financial instruments that few people understood. Robert Rubin, the Treasury secretary under President Bill Clinton, told “The NewsHour With Jim Lehrer” that most people who deal with these instruments “probably do not fully understand all the risks that are embedded in those instruments that can materialize under unusual circumstances.” These ill-understood instruments were then bundled and sold multiple times, like hot potatoes, to other investors.

C.E.O.’s were not the only ones who profited from the “credit culture.” Ordinary people grew complacent in the growing value of their single major asset, their homes, and refinancing became commonplace across the middle class. Loan officers offered mortgages to customers who were not credit-worthy. This practice preyed on the poor, but for others it fostered a credit culture in which speculating in real estate was as easy as visiting the nearest bank. Popular television shows, like A&E’s “Flip This House,” promoted get-rich-quick schemes for the middle and upper classes.

Since the days of the Carter administration, deregulation has been a bipartisan policy. Regulation during the Clinton and Bush administrations, however, was particularly lax. As long as the Dow kept rising, both were reluctant to place any restrictions on new financial instruments. The present administration could, for example, have empowered the Treasury Department to study more closely the reasonableness of mortgage-backed securities. Indeed, William H. Donaldson, a Republican who served as chairman of the Securities and Exchange Commission, resigned his post after the Bush White House resisted his pleas for greater regulatory oversight.

The debacle offers a warning to those who place their faith in a market system free of regulation. The “efficient market hypothesis”—the notion that the market optimally allocates resources—assumes that full information will enable investors to weigh risk carefully when making investment decisions. On this assumption, poorly performing C.E.O.’s and fund managers would be penalized by falling stock prices and poor financial reports. Yet when the information is so complicated that few—even those on boards of directors—can understand what is being traded, we see what economists all too coolly call “market failure.” In such circumstances governments must regulate.

Given the globalization of debt in today’s financial networks, Secretary Paulson’s proposal for a bailout is necessary to avert a worldwide economic meltdown. The failure of mortgage brokers, investment houses and A.I.G. makes the future prospects for ordinary people ever more precarious. The cost of the bailout will also make the government less capable of assisting the needy both at home and abroad for a very long time. Even before the present crisis, the rise in the price of foodstuffs and gasoline had precipitated food riots around the world. Saving the financial institutions will provide only a limited cushion for those always most vulnerable—the poor and the lower-middle class. Here in the United States, they will find it harder to obtain home mortgages. Globally, the millennial hope of cutting world poverty in half by 2015 will almost certainly become a faded dream.

Still, as the bailout endeavors to prevent an even more dire collapse, steps must be taken to prevent worsening impoverishment at home and abroad. Without equity, there will be no financial stability. The test of leadership will be to articulate a new design for the economy predicated on human solidarity, in which the costs will be fairly allocated and the benefits shared by all. For the burdens must be borne for generations to come. It will take rare honesty, an exceptional degree of persuasion and an unswerving sense of justice to lead the nation on a new path. It is time to pull together for the common good. Self-interest has had its day and has failed us all.

Robert Rubin is certainly right in stating that most people do not understand the risks inherent in complex financial instruments. But one can be certain that when government implicitly guarantees a bailout with government sponsored enterprises such as Fannnie May and Freddie Mac, the taxpayer will eventually pay. More regulation? Regulations are already too complex to comphrend and can never compensate for the moral hazard of free money that induces all of us, whether we be homebuyers or bankers, to live irresponsibly as well as explore loopholes and self-serving legislation. And we can also act irreponsibly as bleeding hearts such as with the enactment of the 1977 Community Reinvestment Act that had banks lending where the market would not go. Politicians, of course, do not pay the consequences of their good works, taxpayers do.

One point of Secretary Paulson's bailout proposal is not mentioned at all in this editorial. It is the point I find most important. Our government does not have the money for this proposal. Every penny of the estimated $700 billion is to be added to our debt. This is a 100% leveraged speculation in assets which will be chosen precisely because they are currently performing poorly! I cannot believe that there is any possibility of this plan's succeeding in the long term. What it will do, if it works at all, is to postpone the crash until its effects will fall on our children rather than on us. Can anyone explain to me how such a plan can be justified morally?

The economy will not be healthy here unless the cause of the malaise is admitted. Too many folks were given worthless mortgages because they could not afford them while folks at Freddie Mac and Fannie Mae profited. There should be no bailout. There should be accountability. The culprits are known and should be called on the carpet.

For the sake of accuracy, it is incorrect to characterize what has occurred on Wall Street as a "market failure". A market failure occurs when it is impossible for a private party to appropriate the gains or losses from a putative exchange. Far from it in this case: the legislation that deregulated what are popularly called "toxic assets" did precisely the opposite. It informed the major players in the market that they now had a green light to trade and presumably profit from these instruments with impunity: that explicitly deregulated exchanges enjoyed a clearly specified legal status--they no longer existed in some electronic netherworld. There was a catastrophic failure of risk management, and this, I suspect, was better understood than Mr Paulson or any of his friends on the Street might retrospectively admit. When you bet the farm and you win, you somehow look smart. When you lose, you come crying to the Treasury to make you whole. The hypocrisy of this sorry mess is simply staggering: it was connived at by both parties, and represented the outcome of several years of sustained effort by the Treasury, the Fed and both Houses of Congress. Please don't confuse the issue. The market worked, but the consequences are simply too awful to contemplate.

I appreciate the balance and tone of the article. I'm the knee-jerk type who all too easily places blame only upon the Republicans, but the failure of the Democrats to stand up for the principles of the New Deal and to make sure that our mixed economy protects the poor, the aged, and our children's prospects is, I must admit, equally reprehensible.

It is not helpful to ignore that loans were mandated by the government to be given to people that could not repay them if push came to shove. That was done in the name of solidarity; surely, everyone had the right to a house of his own. Let us please not now call for more solidarity and equity.

"The test of leadership...new design...predicated on human solidarity ... burdens ...borne for generations to come. ...rare honesty, ...exceptional ...persuasion ...unswerving sense of justice ...new path. ...time to pull together ...common good. Self-interest has had its day and has failed us all." You forgot "hope" and "change." No offense, but in all honesty, this could have come right out of Marx' Das Kapital!

Consider why no one proposes that the government buy the actual foreclosed properties, instead of the debt, so that it can then offer them to low and no income people as residences at affordable rent-to-own terms and thereby establish a floor for this melt-down upon which businesses can restructure themselves. Is it fear that the lifestyles of those at the top will have to change?

Your analysis of the financial crisis leaves out a crucial component which has nothing to do per se with regulation. Congress in a sense caused this crisis by forcing financial institutions to give mortgages to bad risks to combat redlining and as a form of social engineering. Hence a lot of risky paper was floated on the theory that everyone has a "right" to home ownership. Add to this Freddy Mac and Fannie Mae, (which you mention but you don't get into), and the corruption of these outfits which was largely a Democrat baby. Franklin Raines an Obama economic advisor made 90 million. Franklin Raines, CEO (Fannie Mae) from 1999-2004, is the individual most responsible for the subprime mortgage crisis. It was on Mr. Raines’ watch that Fannie Mae went bankrupt. Add to this the stonewalling of any attempts at reform (McCain tried; Bush tried albeit without passion) there by Barney Frank, Chris Dodd et al. It's ludicrous to hear Frank pontificate about the crisis when he nurtured it along. Yes,there is plenty of blame to go around but you leave out a key component which is largely a Democratic affair. The FBI investigation should bring this out. There should be no bailout with taxpayer money. At best there should be a loan so that Wall Street has to pay the penalty for stocking up on risky/bad paper generated by Congres via the corrupt Fannie Mae/Freddy Mac conglomerates.